Domestic Commercial Property

Updated February, 2006
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Like commodities, commercial property is another asset class that has seen a sharp increase in prices over the past few years. One part of its attraction is clear. More and more countries have legalized the use of vehicles known (in the U.S. and Canada) as real estate investment trusts (REITs). These vehicles own commercial property, trade publicly, and are usually exempt from corporate taxes provided they pay out a high percentage of their earnings (e.g., 90%) as dividends to their shareholders. In an era where current income returns on many other asset classes are quite low, the relatively high dividend yields offered by REITs have attracted the interest of many investors.

Once again, however, the question must be asked: have the high returns on commercial property securities in recent years represented too much of a good thing? Are they now overvalued?

We will begin our analysis with a brief overview of the classic commercial property cycle, which is summarized in the following table.

Let us start from the third column, when an economy begins to come out of recession. Vacancy rates begin to fall, and rents begin to rise, while interest rates are low. Since the market value of a commercial property is equal to the capitalized value of its expected rental income stream, the rise in rents leads to in an increase in property values. As the economy nears the peak of demand growth, rising property values (driven by further increases in rental income) have triggered an increase in new construction activity. Some of this comes onto the market after the economy has passed its peak, which accelerates the fall in rents and (along with rising interest rates), causes a decline in property values which continues through the bottom of the economic demand cycle.

To be sure, it can be argued that different types of commercial property pass through this cycle at different speeds. For example, the valuation of retail properties (where rents are driven by consumer spending) seems to track the economic cycle more closely than the valuation of office properties (that tends to track employment growth, which lags demand growth). That being said, one way to answer the valuation question is to ask which stage of the economic cycle we are in today. The recent experience of strong demand growth and rising interest rates suggest column four, which implies that commercial property values are peaking.

Another way to approach this question is via The Index Investor equity valuation model (since REITs are traded on the public equity market). As you recall, this valuation model has two parts: the returns companies are expected to supply, and the returns investors logically demand. In a market in equilibrium, these two will be the equal; however, as we have noted, since the financial markets are a complex adaptive system, they are usually not in equilibrium (though they are strongly drawn towards it).

Let's start with the returns that companies are expected to supply. They are estimated as the sum of the current dividend yield on a stock (or market) and the rate at which these dividends are expected to grow in the future. Unfortunately, while the current dividend yield on commercial property securities is easy to obtain, the rate at which dividends are expected to grow in the future can only be assumed. This task is made much harder by the relative scarcity of historical data for commercial property securities, which are relatively new in many countries.

The returns that investors demand are also composed of two parts. The first is the current yield on real return government bonds, which is the basic building block for all financial asset returns. The second is a premium that reflects the relative riskiness of the asset class in question. In this case, like many others we have judged the riskiness of liquid commercial property securities to lie in between investment grade bonds and equities; the specific risk premium we use in our asset pricing model is 2.5%.

Since the future rate of dividend growth is so hard to estimate, one way to approach the valuation question is to assume the market is in equilibrium, and that the returns the market is expected to supply equal those rationally demanded by investors. This allows you to derive the rate of growth by subtracting the current dividend yield from the sum of the current real bond yield plus the assumed commercial property risk premium. This calculation is shown in the following table for five markets with significant trading volume in commercial property securities.

As you can see, this approach yields negative expected dividend growth rates. On the one hand, this is consistent with the view that we are approaching the top of a commercial property cycle. On the other hand, it is probably inconsistent with the expectations of a lot of people who have been investing in commercial property securities on the assumption that they are not currently overvalued.

To put this issue in perspective, the following table shows the implied real growth rates that result from using different assumptions about investors' required risk premium for holding commercial property.

As you can see, it is not until the assumed risk premium reaches 4% to 5% that the implied growth rates all get into a range that many commercial property investors might consider a reasonable assumption. This strikes us as unreasonable for two reasons. The first is that an excellent recent study estimated the risk premium of four percent for directly owned commercial property, which is significantly less liquid, and therefore riskier than commercial property securities (see "The Performance of Real Estate Portfolios: A Simulation Approach" by Fisher and Goetzmann of Yale University).

Second, assuming a 4% to 5% risk premium for liquid commercial property securities also implies that investors simultaneously believe that although we have not reached the peak of the commercial property cycle, equity securities (which should require an even higher risk premium than commercial property securities) are already extremely overvalued.

Based on the rule, "choose the simplest hypothesis", we conclude that it is most likely that we are approaching, or at, the top of a commercial property cycle. This conclusion is corroborated by a new report from HSBC Bank, "A Froth Detecting Mission: Detecting U.S. Housing Bubbles." It finds that "about half of the US housing market is frothy and that this 'bubble zone' may be overvalued by as much as 35-40%, after taking into account low interest rates and tax advantages. Current valuations imply [either] a large permanent reduction in the risk premium and/or a sizable step up in future capital gains, not all of which, we think, is justified. The 'bubble zone' accounts for 50% of US GDP, or over US $ 6 trillion, nearly the size of the German, French, and UK economies put together. In other words, it's big. Therefore, when these housing bubbles begin to deflate, it is likely to have substantial macroeconomic consequences." Moreover, as The Economist global house price index has repeatedly demonstrated, this is not a phenomenon limited to the United States. Arguably, housing bubbles are already deflating in Australia, the United Kingdom, South Africa and Spain. If residential housing markets are at (or beyond) peak valuations, why should we not expect the same to be true of commercial property valuations?

Again, we note the difficulty of trying to time markets. If an investor has already made his or her allocation to commercial property, and if that allocation is currently above its target portfolio weight, this would be a good time to rebalance, perhaps to a level somewhat below the target weight. On the other hand, if an investor has not yet made his or her allocation to commercial property, we believe that the prudent course of action would be to defer any reallocation until the valuation of commercial property securities have declined from their current levels.

January, 2006

Property is the world’s largest asset class. Unfortunately, it is also one of the most opaque. Unlike most other asset classes, the assets in question are dissimilar, and trade infrequently at high transaction costs in markets where data collection efforts lag far behind those in markets for more liquid financial assets. Moreover, unlike the markets for financial assets, there are far fewer opportunities for shorting over-priced assets, and supply responds much more slowly to changes in demand, which sets the stage for repeated boom and bust cycles. Given that, we should say up front that we believe the conclusions we will draw in this section, while directionally correct, are less precise than those we draw where better data is available.